BKX Put Option Spread Idea

The KBW / Philadelphia Exchange Bank Index, or “BKX” is a market capitalization weighted index focused on the biggest banks in the U.S. markets. Its components and their respective weightings are:

The largest weightings are JP Morgan (JPM), Citigroup (C), Bank of America (BAC) and Wells Fargo (WFC), which collectively are roughly 25% of this index. A historical price chart of the banking index follows.

Friday, February 29^th’s action in the financial index was a fairly significant move to the downside, on a market-wide sense that inflation is a continuing problem in our economy, and the Federal Reserve is not able to fight battle effectively with just rate cuts. The economy has likely already gone into a recession, and if you combine a recessionary environment with the housing / mortgage related issues that are facing banks, it has become somewhat (in this analyst’s opinion) a “perfect storm” for banks and banking stocks.

First, some details about a put spread:

To construct this spread, we are recommending investors buy one April-08 85 strike Put option at a limit price of $6.60, and on a one-to-one basis, sell one April-08 75 strike Put with a limit price of $2.00. At those levels, this spread has a current “fair” price of approximately $4.60, before commission. The bid / ask spreads on this index are quite wide at current, so stick with a “net” cost of this spread at $4.60. With the current index quoted at 82.07, we are recommending:

• Buy One April 85 put ($6.60) Cost to purchase

• Sell One March 75 put +2.00 Credit to seller

• Net Cost ($4.60)

What do I want this trade to do?

You want the index price to close at or below your lower strike ($75) at expiration on April 19^th, 2008.

What is the Maximum Value of the Spread?

The maximum value of this spread is $10.00 (the value of $85 less the value of $75 – the respective strike prices on the purchased and sold options).

How much can I make on this Spread?

Investors who benefit from a decline in the BKX Index’s price past the 75 level, with this position on will benefit by roughly $5.40. The maximum value of the spread ($10.00) less what you payed (net basis) for the spread ($4.60 in our example) is your maximum profit level.

What is my Maximum Risk on this Spread?

$4.60, or $460 per contract. Your maximum risk in this spread is what you paid for the spread.

Should I “take the offer” and “hit the bid” when I construct this trade?

No. Work with your broker to pre-determine what your “net cost level” will be. .. And stick to it! Many exchanges now offer the ability to place a proper multi-sided spread as a packaged order. If your broker doesn't know what to do, or you need help, contact an options professional that does know how to do it.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in the BKX index or options on the BKX index.

Comments

[VladimirSenkov]

Interesting idea. While your theoretical exposure is indeed limited to the premium differential, I would be worried about exercise risk. Please correct me if i'm wrong, but let's consider this scenario:
Suppose you've sold $99 put and bought $100 put on a volatile stock. It's expiration day and the stock is trading just above $100. Suppose options are trading at a wide spread again, just like the day you made your first trade, arbitrageurs aren't touching it with 10 ft pole and buying your spread back isn't a good option at this point.
You need to make a decision if you want to exercise your option or not. Your deadline to make this call may not be the same as for the guy who bought your option. He is probably one of the arbitrageurs and has better access to the market. Your broker probably made you sign an agreement with a fine print that sets a draconian dead line. You let the deadline pass. Then something big is announced and stock is trading at $90. You've just lost another $9 that you were not planning to lose. They won't let you exercise your $100 put after your deadline has passed.
Having said that in this particular scenario i think you're relatively safe.

[Vikram]

There are other instruments like the XLF which have much more liquid option markets. Options trading on the AMEX can have very large spreads and the risk of assignment is much higher since the liquidity is low. The XLF should be very strongly correlated to the BKX.

[Reinhard]

Hmmm, one time you wrote April $75 put and the other time March $75 put. The latter is actually what I do a lot. I always buy the upper put with twice the duration as the lower put. That way, the written put decays faster, and it gives me more freedom to react, depending where it is after a few weeks. I can then write another put at a lower price potentially for the second time interval.